Case — Corporate Officer – Contractor vs. Employee

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TL Case Summ

THE QUESTION

Is the president of a corporation an employee or an independent contractor for purposes of deducting business expenses?

THE DISPUTE

Taxpayer Says: He was an independent contractor or statutory employee and is entitled to deduct business expenses in full on Schedule C.

Internal Revenue Service Says: The taxpayer was a common law employee. Unreimbursed expenses he incurred are properly claimed on Schedule A, Itemized Deductions, subject to the 2% of adjusted gross income limitation.

THE LAW

From Internal Revenue Code Sections 62(a)(2), 63(a), (d), 67(a) and (b), 162(a): An individual performing services as a common law employee may deduct expenses incurred in the performance of services as an employee as miscellaneous itemized deductions on Schedule A to the extent the expenses exceed 2% of the taxpayer’s adjusted gross income.

From Internal Revenue Code Section 3121(d): Defines “employee”, in pertinent part, as follows: (1) any officer of a corporation; or (2) any individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee * * *.

From Federal Tax Regulation 31.3121(d)-1(b): An “officer of a corporation who as such does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration is considered not to be an employee of the corporation.”

From Federal Tax Regulation 31.3121(d)-(1)(c)(2): Whether an individual is an employee or an independent contractor is a factual question to which common law principles apply. Factors that are relevant in determining the substance of an employment relationship include: (1) the degree of control exercised by the principal over the details of the work; (2) the taxpayer’s investment in the facilities used in his or her work; (3) the taxpayer’s opportunity for profit or loss; (4) the permanency of the relationship between the parties; (5) the principal’s right of discharge; (6) whether the work performed is an integral part of the principal’s regular business; (7) the relationship the parties believe they are creating; and (8) the provision of employee benefits.

From Rev. Rul. 90-93: A statutory employee under section 3121(d) is not an employee for purposes of section 62 and may deduct business expenses in full on a Schedule C.

From Rosato v. Commissioner, T.C. Memo. 2010-39: An individual who performs services as an independent contractor is entitled to deduct expenses incurred in the performance of services on Schedule C and is not subject to limitations imposed on miscellaneous itemized deductions.

From Ewens and Miller, Inc. v. Commissioner, 117 T.C. 263, 269 (2001): An individual qualifies as a statutory employee under section 3121(d)(3) only if the individual is not a common law employee pursuant to section 3121(d)(2).

THE CAUSE OF THE DISPUTE

Generally, S corporation officers and/or shareholders who provide more than minor services to their corporation and receive, or are entitled to receive, compensation are subject to federal employment taxes. If an officer does not perform any services or only performs minor services and is not entitled to compensation, the officer is not considered an employee.

Besides the issue of who pays the employment tax, another difference between being classified as an employee instead of an independent contractor is the way business expenses can be deducted. When you’re an employee and you incur expenses in connection with your work, those expenses may be deductible as a miscellaneous itemized deduction. When you’re an independent contractor, you can deduct expenses incurred in connection with your work on Schedule C (Profit or Loss from Business), as a direct reduction of the income you earn from the work you perform.

In this case, the taxpayer owned 33.3% of a mortgage company. He was president of the company and worked as a mortgage loan officer for the company. He did not receive base pay or employee benefits, and was paid solely on the basis of commissions. The company did not provide him with potential clients, direct the solicitation of clients or closing of mortgage loans, or provide him with space in which to conduct business.

For the year in question (2007), the company issued Form W-2 to the taxpayer for amounts paid to him during the year, and withheld federal and state income taxes and social security and Medicare taxes from his pay. Prior to 2007, the taxpayer had received Form 1099-MISC (Miscellaneous Income).

The taxpayer reported the W-2 wages on his 2007 federal income tax return. He also claimed a home office deduction, and reported expenses related to the income from his work as a mortgage broker on Schedule C. Because he did not control the company, and the company did not control his hours of business, office location or how he obtained his clients, he believed he should have been treated as an independent contractor, and that he was therefore eligible to deduct his expenses on Schedule C, which provided a better tax benefit.

The IRS disallowed the deductions, arguing the taxpayer was a common law employee of the company and his business expenses were therefore only deductible as an itemized deduction.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 38KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
Sorry, wrong answer :(
For the taxpayer. Considering the record and weighing the factors, taxpayer was an independent contractor in 2007. Taxpayer is entitled to deduct business expenses on a Schedule C to the extent substantiated.
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